A Default by Any Other Name: History of Credit Crises Shows Countries’ Experiences Vary Widely

Wall Street Journal

Not all government debt defaults are created equal. A default—the failure of a creditor to repay a scheduled interest payment or capital repayment in full and on time—can occur with the consent of creditors or without. History shows defaults can deliver rapid benefits to a borrower or destroy confidence in its economy for years; they can shake the financial system, or not. The technical definition of default varies among credit-rating agencies, accountants and lawyers. And a default as defined by a rating agency isn’t necessarily a « credit event » that would lead to payouts to holders of credit-default swaps, which are a form of insurance against nonpayment of debt.

Although some options now being considered for Greece’s bailout package would be defined as a default by the rating agencies, they wouldn’t all force bondholders to take explicit losses—or « haircuts »—on their bonds. Many analysts believe, because of Greece’s heavy debt burden, that such losses are highly likely in the years to come. But providing Greece gets more bailout money by Aug. 20, when €5.9 billion ($8.6 billion) of government bonds come due, many analysts say that, even if Greece’s second bailout leads to a default, it shouldn’t generate a financial crisis this year.

Whether a crisis follows default depends on the uncertainty generated in the financial system, the scale of the likely losses, and the financial strength of the holders of the debt. What happens to Greece this year is unlikely to come anywhere close to the panic generated in August 1982 by Mexico’s announcement that it couldn’t meet its debt obligations. William Rhodes, then a senior Citibank executive who helped manage the ensuing crisis, says in a new book that the Mexican announcement triggered fears of a « wave of defaults [that] could destabilize the global banking system and throw the entire world into a depression. »

The first step was to get agreement on « new money » from banks and international organizations led by the International Monetary Fund, on extensions of debt maturities, and on the imposition of austerity measures. The response, repeated across Latin America as other borrowers suffered from contagion, was similar to that now being discussed for Greece. The difference is that the lenders were international banks—then smaller in number and perhaps easier to herd by Mr. Rhodes than the heterogeneous band of creditors who now holds Greek bonds. It was only in the late 1980s that the U.S. and others formally recognized what many had thought from the start: Mexico’s debts would never be paid in full. The U.S. Treasury, under then-Treasury Secretary Nicholas Brady, pushed a plan for a debt exchange: old loans for new bonds that would be less burdensome for the debtors but would contain sweeteners, such as interest guarantees, to encourage creditors to exchange. But the key to the eventual success of the plan was that the banks, once mortally threatened by the crisis, had had time to build up financial cushions. When the bond exchanges took place, the banks were able to release some of their excess provisions to their bottom lines.

The 1990s were marked by periodic crises: Mexico again in 1994, and Venezuela, Russia and Ukraine in 1998, for example. Each found a slightly different way to build up excessive debts, sometimes through the short-term debt and bond markets.

In January 2002, Argentina missed a payment on its foreign debt. A bond exchange followed, in which bondholders received haircuts of 70%. The Argentine economy subsequently enjoyed rapid growth—a recovery some analysts point to as evidence that there is life after default. However, Argentina’s debt crisis didn’t trigger a crisis for creditors, and at that time, the international economy was also embarking on a period of sustained growth, which lifted the Argentine economy too. It isn’t clear that the economic tailwinds behind Greece would be so strong.

Rating agency Moody’s Investors Service lists 16 sovereign defaults of countries it has rated since 1983, the latest being Jamaica in early 2010. Its list doesn’t include defaults by sovereign borrowers that it didn’t rate. Not all defaults end in long-term disaster. Take Uruguay. Contagion from Argentina led its neighbor to complete a distressed debt exchange in 2003. The exchange was announced on April 10; on May 16, Standard & Poor’s lowered the rating to a « selective default, » and on June 2, it raised the rating to B-minus, when the debt exchange was completed—on the basis that Uruguay’s debt was more sustainable than before. The default lasted 17 days.